A Tale of Two Markets

Bernie
Schaeffer uses a unique blend of fundamental, technical and
sentiment data to assess the markets. His latest such assessment leaves him
bearish on blue chips and bullish on the small caps. Here's his analysis
and suggestions to play these seemingly opposing trends.

"The Dow remains the
'headline number' that represents 'the market' to the tens of millions who have a casual
interest in stocks. And the public's perception of stock-market conditions
has been skewed positively in recent years by the abnormal relative strength
in the Dow. The major contributing factors to this strength have, in my opinion,
been heavy short interest and a major rally in the cyclical stocks that dominate
this index. Heavy short interest provides the backdrop for sharp rallies due to
urgent short covering. And nowhere has this been of greater importance than in
the Dow Diamonds Trust (DIA
ASE), an exchange traded fund keyed to the Dow.

"The bottom line is not certainty that the market is about to
fall apart here. But risk is abnormally high and
there is a much greater-than-average chance of the market seriously weakening. The
notion that 'safe stocks' will protect you from a weak market is nonsense. These
are the same stocks that have been favored by the plodding (and serially
underperforming) institutions, who will be the first to be trying to squeeze out
the narrow exit door should the market drastically weaken.

"Over the past three years, the Dow has failed
three times at the 10,700 area. Notably, the failures in 2001 and 2002 were
followed by sharp declines in the Dow. What's more, the 2004 peak
fell just shy of the 50% Fibonacci rally off the Dow's October bottom
at 7197. Despite these warning signs, skepticism is waning, as DIA short interest declined from
28 million shares in mid-February to 20.75 million shares in mid-March. Should DIA
short interest continue to decline, it will have increasingly bearish
implications for the Dow. For options investors, we recommend buying the
Dow Diamonds January 2005 108 put."

"At the same time that I am cautious on the
Dow, I'll make the case for holding a decent portion of your invested assets in
the small-cap arena, as exemplified by the Russell 2000 Index, which we would
play via the iShares Russell 2000 (IWM
ASE), an exchange traded fund that tracks the broad-based small cap Russell index. We spend
a great deal of time reviewing the financial media for clues about the
general sentiment backdrop. For over a year, the chorus from Wall Street has been very
consistent regarding small caps vs. large caps and it can be summarized: 'The
small cap rally has been overdone. Switch to the safer large-cap names.'

"While the bullish case for small caps is fairly strong, it
comes with the warning that this is a risky and dangerous market
environment. Should the blue chips mount a serious decline, there will be no
place to hide in the small caps (though I do believe they would hold up as well,
if not better, than the big caps). But should the market stabilize and/or rally
from here, I believe the small caps will continue to provide much higher
relative gains. So small-cap exposure does make sense to me, assuming it's
within the context of a portfolio heavy in cash."

"Meanwhile, pessimism
continues to run rampant toward small-cap stocks. Options players have recently piled
into IWM April puts at a faster rate than calls. Adding to the buildup of
pessimistic sentiment, short interest soared 13% in March to 27.2 million shares. Not
only is this a new multi-year high, but it would take more than
four days to cover these bearish bets. This accumulation of short positions could
easily fuel a covering rally. We're looking for an oversold bounce in the
index, which could be supported by added buying as the shorts cover their bets.
For options players, we recommend the iShares Russell 2000 Index August 113
call."